Well, the parties seem to have done the homework to which they were set by The Great Dissenter, a/k/a The Judge Who Writes Like a Human Being, s/a/k/a The Implacable, Illustrious, Incontrovertible, Insuperable, Ineffable, Ineluctable and Indefatigable Foe of the Partitive Genitive, Old China Hand and Master Silt Stirrer, Judge Mark V. Holmes. And the result is anything but jolly for IRS, who argued that the sale of waste collection, recycling and landfilling agreements with various CA municipalities generated ordinary income and not capital gains.

Question presented: Are these agreements “franchises” within the meaning of Section 1253?

“The Greenteam partnerships’ argument is simple. The sales of the contracts fall under section 1253, which says that a taxpayer gets capital-gains treatment when it sells a ‘franchise’ unless it has a continuing interest in the franchise after the transfer. The Commissioner disagrees. He thinks section 1253 doesn’t apply precisely because the Greenteam partnerships didn’t keep any interests in the contracts and didn’t receive any contingent payments. The Commissioner says that since section 1253 doesn’t apply, we have to decide whether the contracts were capital assets by looking at section 1221, the six-part multiprong test of Foy v. Commissioner, 84 T.C. 50 (1985), and the substitute-for-ordinary-income doctrine. The Greenteam partnerships think they still win under Foy.” 2017 T. C. Memo. 122, at pp. 11-12.

Well, they are franchises. IRS’ argument that franchises are only private deals and not deals with municipalities goes down.

“Section 1253(b)(1) defines ‘franchise’ for the purposes of that section: Franchise.–The term ‘franchise’ includes an agreement which gives one of the parties to the agreement the right to distribute, sell, or provide goods, services, or facilities, within a specified area.

“The definition is unambiguous, so we need only look at the plain language of the statute. Section 1253(b)(1) tells us that there’s a ‘franchise’ for the purposes of section 1253 if there is: an agreement in which one party receives the right to provide services within a defined area. If a transaction satisfies these three requirements, then it falls under section 1253.” 2017 T. C. Memo. 122, at pp. 12-13. (Citations omitted, but get them for your memo of law).

IRS trots out a new argument, that under CA law and usage, the contracts aren’t franchises but indefinitely renewable annual contracts, known as “evergreens.” So what, says Judge Holmes; “The Commissioner’s problem is that the industry definition in California doesn’t matter for federal income-tax purposes.” 2017 T. C. Memo. 122, at p. 15.

But that isn’t the end of the search. It may be that the Greenteam sold franchises, but are the gains capital or ordinary?

“Holding that section 1253 includes the contracts here as ‘franchises’ isn’t the end of the matter. We also need to figure out whether the Greenteam partnerships kept any ‘significant power, right, or continuing interest’ in the franchises. If they did, their income from the sales is ordinary. See sec. 1253(a), (b)(2); see also Rev. Rul. 88-24, 1988-1 C.B. 306. But that’s an easy question here–none of the Greenteam partnerships kept any interest in the franchises, and they didn’t receive contingent payments–they got lump-sum payments. Even the Commissioner concedes in his briefs that the partnerships didn’t hold onto any significant interests in the franchises or receive contingent payments. Since we are dealing with franchises under section 1253, and the partnerships didn’t keep any interests in the franchises or receive contingent payments, we know the transactions aren’t ineligible for capital-gains treatment. See sec. 1253(a).” 2017 T. C. Memo. 122, at pp. 15-16.

The Greens claim that satisfying the Section 1253 franchise definition means automatic capital gains treatment. But section 1253(a) only says what isn’t a capital gain, not what is.

Judge Holmes and Section 1253(d)(2) to the rescue.

“Any amount paid or incurred on account of a transfer, sale, or other disposition of a franchise, trademark, or trade name to which paragraph (1) does not apply shall be treated as an amount chargeable to capital account. [Emphasis added.].” 2017 T. C. Memo. 122, at p. 16.

Anyway, Tax Court dealt with this one too.

“Our Court has already addressed this issue too. In Jackson v. Commissioner, 86 T.C. 492, 520 (1986), aff’d, 864 F.2d 1521 (10th Cir. 1989), we held that section 1253 gives a transferor of a franchise capital-gains treatment so long as it doesn’t retain any significant interest in the franchise and the franchise was a capital asset. The Fifth Circuit agrees. It also explained that section 1253(a) says a taxpayer doesn’t get capital-gains treatment when it transfers a franchise if it retains a significant interest in the franchise. McIngvale v. Commissioner, 936 F.2d 833, 839 (5th Cir. 1991), aff’g T.C. Memo. 1990-340. McIngvale also said that section 1253 assumes the inverse too–when a taxpayer transfers a franchise and doesn’t retain a significant interest, the transaction is taxed as the sale or exchange of a capital asset. Id.” 2017 T. C. Memo. 122, at p. 17. (Footnote omitted, but read it; legislative history and more cases for your memo of law).

The Greens win.

I cannot find in Judge Holmes’ opinion any reference to IRS advancing “a good faith argument for an extension, modification or reversal of existing law.” See ABA Model Rules of Professional Conduct 3.1. Maybe the Greens should go for legals and admins. Or something else.

An author, teacher, advocate and trusted advisor, Lew Taishoff is a New York City-based attorney with 52 years of experience in corporate and individual tax and real estate matters. He is an Enrolled Agent, examined and admitted to practice before the Internal Revenue Service, and admitted to practice before the ... Continue reading →